Educational Articles

What Makes a Good IPO?

Steven Shnayder
| December 29, 2011

The now-ending year gave birth to some high-flying and much-anticipated initial public offerings (IPOs), including the likes of daily deals supersite Groupon (GRPN), professional networking site LinkedIn (LNKN), and urban car rental service Zipcar (ZIP). Nearly a decade after the IPO frenzy of the late 1990s led to a stock market implosion and subsequent bursting of the so called Internet bubble, such stocks are once again leading today’s IPO bull market. However, some other IPO’s such as Spirit Airlines (SAVE) and GNC Holdings (GNC), which have been garnered less attention, are also worth taking a look at following their collective moves to the upside. Value Line, however, is not as concerned with what a freshly issued stock does on the day that it goes public, or even the day after that, but rather with the underlying business and what happens in the subsequent months and years that follow.

It is hard enough determining the true value of a stock that has been public for a number of years, even though there is often a wealth of historical data to examine. With an initial public offering (IPO), there is little information to go on. Moreover, because many IPOs are of technology companies with high growth prospects, historical data is often of little use.

Granted some businesses have been in existence for years before they decide to “go public”, and they may have a variety of reasons for doing so; the business may wish to raise capital for expansion or to pursue growth opportunities that can only be accomplished through the tremendous influx of cash that usually comes with a public offering. But, many other companies decide to take to the equity markets after only being around for a short time, and it is in those instances that investors need to exercise the most caution and be especially wary.

To determine what makes an IPO a winner, or more often than not, a less-than-stellar investment, one should first understand what an IPO is and what purpose it serves. An Initial Public Offering occurs when a company decides to sell shares to the public for the first time. This is usually accomplished with the help of one or more investment banks, who typically underwrite an issue. The banks determine what they deem to be a fair value for the company’s shares and then sell them to their institutional clients and retail investors. For this service the issuer pays the investment bank a fee. Depending on the nature of the business and the ease with which the bank thinks it can sell the shares, the underwriting contract can take several forms including a best efforts contract, a firm commitment, or several other varieties. This can be an important consideration, because the form of the contract may determine the pricing of the offering.

One of the greatest stock market anomalies is the initial “under” pricing of IPOs. Although there are a number of reasons for this, one explanation is to protect the underwriter if it has agreed to sell the company’s shares on a firm commitment basis. This means that the bank has agreed to purchase all of the issuer’s shares to be offered to the public outright and will then try to resell them at a specified price. If the bank overprices the issue, it may not be able to sell those shares to the public, and will suffer a loss as a result. Another explanation is that the bank has an interest in generating trading volume for the new issue. Either way, if an issue is underpriced, then in theory, it should be a good investment. But the caveat is that only a select few institutional and privileged clients can “get in” at the offering price. Most retail investors will only be able to buy the stock after the shares have “popped” or appreciated significantly in early trading.

As an example, look no further than LinkedIn, the professional networking site that made its debut on the NASDAQ in early June, 2011. Shares were initially priced at $45, but sold at $83 on their first day of trading, and appreciated to over $100 a share thereafter. This sort of allocation structure results in those investors that were allocated shares first benefiting at the expense of those who were only able to buy-in later on. Furthermore, evidence suggests that long-run average annual returns for IPOs over a period of five years are less than those for comparable companies whose shares are already outstanding. In addition, studies have found that the IPOs of smaller companies tend to perform even worse than their larger brethren over the same period of time.

So why then, do investors clamor for these issues if their performance has not been all that impressive historically? One explanation is that investors hope that an IPO will turn out to be the next Google (GOOG) or Microsoft (MSFT - Free Microsoft Stock Report), but unfortunately, the overwhelming majority of new issues will not live up to those kind of expectations. Often investor optimism about the growth potential of companies going public manifests in triple digit price to earnings multiples (or worse if the company does not have any earnings and trades merely on sales). In our opinion, this is not prudent investing, because the market’s rosy expectations often prove unattainable.

However, the point is not to discourage anyone from investing in IPOs, as there are often good choices out there. Like any other investment, however, it is important to look at the fundamentals of the underlying business to see whether they are sound. Is the company selling the investor on unrealistic projections, or does it have current earnings and a sustainable business model? How difficult is it for other businesses to try to break into the same space? For example, when Google went public in 2004, the company’s shares traded at $85 and had a total market capitalization of $27 billion, which seemed lofty at that time. However, the Internet search giant wasn’t just promising investors that it would “blow up” into the company it is today. Google had real earnings at that time of $143 million dollars through the first half of 2004. This is in stark contrast to companies like Pandora (P) and Zipcar, which may very well turn a profit in the future, but are losing money at the moment. Not surprisingly, both companies have seen their stock prices drop over 40% since becoming actively traded in the second quarter of 2011.

On the other hand, there are several other companies that went public in 2011, which have solid fundamentals and are already profitable concerns. Spirit Airlines, which made its debut at the start of the summer, is one of the few IPO’s that appreciated in price in 2011. The budget airline caters primarily to leisure customers who are looking to travel to places like South Florida and parts of the Caribbean. The airline plans to use the money it received from its IPO to expand its fleet of airplanes and to begin flying new routes in the future. With the economy still struggling, more customers will likely continue to flock to low-cost airlines.

Another tool that investors have at their disposal is to see whether insiders are selling shares or “cashing out” of the company, because if they are, that should send a red flag to investors. Note that insiders are prohibited from selling their shares for a period of 90 days and shares of a recent IPO often decline after this initial lock-up period is over, since insiders will often put in their sell orders as soon as they can.

All in all, we urge investors to avoid speculation and to stick with sound investment principles. The allure of discovering the next “hot” IPO can be great and the potential reward enticing, but these qualities can also be distracting when searching for good investments.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.